Archive for the 'Macroeconomics' Category

Nov 15 2012

Advice for writing a strong IB Economics Internal Assessment on Macroeconomics

My IB year 2 students are in the process of writing their second Internal Assessment commentary (IA), a major component of their grade in the course. Last spring they wrote a commentary on a microeconomic topic, and this time around they are investigating macroeconomic issues to write about. I thought I’d write a quick post to offer some advice for conducting a solid commentary on a macroeconomic topic.

First of all, it should be pointed out that finding a good article to write a macro commentary on should be very easy. Pretty much any newspaper (print or digital) is bound to have a couple of macro-related stories on its front page any day of the week. The tricky part, however, is choosing an article on a topic that interests you, the student. One place to start to look for the perfect article is on the Welker’s Wikinomics Universe page, which includes over 40 live streams from different economics news sources. You can be sure that the articles you find here are current and that the sources have already been filtered by an experienced Econ teacher, so they can generally be considered appropriate. 

WARNING: Make very sure that the article you are considering is NOT a blog post, a commentary or an editorial piece. It is strongly discouraged to write a commentary on another person’s commentary. One way to determine whether an article is a commentary is to look at the URL and if you see words like “blog” or “commentary” or “editorial”, or “opinion”, you should move on to another article.

I recommend my students choose an article about their own home country. This way, they have at least some vested interest in the issues they’re writing about.

Now, how to choose a good article. Below are some of the main themes in Macroeconomics that could serve as outstanding main ideas of an IB Economics commentary:

Economic growth:  The media is obsessed with GDP growth rates, perhaps because society seems to be equally obsessed. Any article about growth (or the opposite of growth, recession), can provide you with lots of points for analysis and evaluation.

  • What are the sources of growth or recession?
  • Who are the winners and losers?
  • What is the government doing to promote growth (or reduce the chance of inflation)?
  • What are the short-run and long-run implications of economic growth for society?
  • Does growth really make us better off?
  • Is growth sustainable?

The tradeoff between inflation and unemploymentThis relationship is best illustrated in the Phillips Curve model. It’s easy to find evidence of this tradeoff in the press, as inflation and unemployment are just behind GDP as the macroeconomic indicators most mentioned in the news.

  • Why is there a tradeoff between these two indicators?
  • What is the relationship between AD/AS and the Phillips Curve
  • When should unemployment be the primary concern of policymakers? When should inflation be the primary concern?
  • What are the effects of inflation on different stakeholders?
  • What are the effects of unemployment on society?
  • How can monetary and/or fiscal policy be used to reduce unemployment OR inflation, but not both?
  • How could supply-side policies be used to bring down both inflation and unemployment?
  • How might negative supply-shocks affect the SRAS and the short-run Phillips Curve?
  • Does the tradeoff between these two indicators hold up in the long-run? Why or why not?

Income inequality: This is perhaps one of the MOST talked about economic topics in the news today. Rising Gini indexes in most developed economies indicate that inequality is growing, and this may be contributing to political and social discontent in the rich world.

  • What are the sources of income inequality?
  • What are the consequences of income inequality? (Economic, social, short-run and long-run)
  • How does inequality affect economic growth? (positively or negatively?)
  • How have government policies in a particular country contributed to growing inequality?
  • How does the free market promote income inequality? (In other words, is it a market failure?)
  •  How can a nation’s tax code and system of social safety nets be used to reduce income inequality?
  • What is the difference between equality and equity?

Fiscal policies: This is a big one. With America’s “fiscal cliff” all over the news and the European debt crisis fresh on people’s minds, it is hard not to find articles about fiscal policy today.

  • How have past fiscal decisions by government contributed to the growing levels of debt in Europe and America today?
  • What role to automatic stabilizers in fiscal policy have in dampening the effects of fluctuations in aggregate demand (either inflationary or recessionary effects)?
  • How does the theory of the Keynesian spending multiplier provide an argument for the use of expansionary fiscal policy during recessions?
  • How does the theory of the crowding-out effect provide opponents of the Keynesian view with an argument against the use of expansionary fiscal policy? (Why might government deficits lead to less private sector spending).
  • What role can fiscal policy play in the short-run and in the long-run in promoting or inhibiting economic growth?
  • What types of fiscal policies (particularly government spending) will best promote long-run economic growth?

Monetary policies: It’s really easy to find news articles in which central banks are mentioned. Whether it’s the “Fed” in the United States, the ECB in Europe, the People’s Bank of China, the Banke of England or the Indian National Bank, central banks are the masters of monetary policy, and the media follows their every move closely.

  • What are the tools of monetary policy and how can it be used to stimulate or contract demand in an economy?
  • When is monetary policy likely to be most effective at reducing unemployment?
  • When is monetary policy likely to be most effective at reducing inflation?
  • Why might a central bank’s primary objective (low inflation) conflict with the macroeconomic objectives of government (low unemployment)?
  • How can monetary policy be used to support a government fiscal policies?
  • What is the risk associated with continually increasing the supply of money in a nation?

Supply-side policies: “Austerity” is a word heard often in Europe today. The fear over large budget deficits has led several European governments to reduce government expenditures drastically on public goods and social spending. This is having major impacts on the quality of life in many European countries, and leading to unrest (and even riots) in some cases.

  • What is the short-run effect of deficit reduction on aggregate demand?
  • What is the argument for deficit reduction? How might such policies help an economy “self-correct” during periods of recession?
  • How will smaller budget deficits lead to lower interest rates in the economy?
  • How does reducing expenditures on transfer payments to the unemployed and poor in the economy promote more flexible labor markets?
  • How might the de-regulation of industry and lower business taxes promote investments that lead to long-run economic growth?
  • How does the supply-sider’s view of the macroeconomy differ from the Keynesian’s view? Which view is more valid?

The ideas above only scratch the surface of the potential areas of investigation a student could pursue in a Macroeconomics commentary. There is one model that ALL macro commentaries should employ, however, and that is the Aggregate Demand / Aggregate Supply model. Nearly every topic in this section of the course requires AD/AS analysis. Otherwise, there are several other models that could be used depending on what specific topic you are investigating. These are:

  • AD/AS
  • Phillips Curve (both short-run and long-run)
  • Lorenz Curve and Gini index (for income inequality)
  • The Laffer Curve (for income inequality or supply-side policy)
  • The Money Market diagram (for monetary policy)
  • The loanable funds market (for fiscal policy)
  • Bond market diagrams (for fiscal policy)

Have you already written a strong commentary on a macro topic? Would you like to your ideas about the assignment? Please post your own thoughts on this assignment below. If you have published your own commentary, feel free to post a link for others to see it!

36 responses so far

Nov 08 2012

Tax progressivity in the US: Do the rich pay more than their fair share? The evidence indicates NO!

Just How Progressive Is the Tax System? – Economix Blog – NYTimes.com

According to a blog post in the New York Times from April 2009, America’s America’s “progressive” tax system is not as progressive as many may believe it to be:

Research has found that many states and local governments have… regressive tax systems… that might offset the progressiveness of [US] federal tax rates.

The research from Citizens for Tax Justice — a liberal organization that advocates “fair taxes for middle and low-income families” — uses 2008 data for all federal, state and local taxes combined. It found that the average effective tax rate is 29.8 percent, and that including state and local taxes makes the tax curve look much less steep:

In the graph above, the horizontal axis shows the income group. The vertical axis shows the percentage of income that the average member of that group pays in taxes. Taxes include all federal, state and local taxes (personal and corporate income, payroll, property, sales, excise, estate, etc.). Incomes include cash income, employer-paid FICA taxes and corporate profits net of taxable dividends.

The article continues:

The group also finds that in 2008 the share of total federal, state and local taxes paid by each income group was relatively close to the share of income that that group brings in, at least as compared to comparable 2006 numbers for effective federal tax rates:

The horizontal axis shows the income group. Taxes include all federal, state and local taxes (personal and corporate income, payroll, property, sales, excise, estate, etc.). Incomes include cash income, employer-paid FICA taxes and corporate profits net of taxable dividends.

The research discussed above poses several interesting questions about the make-up of a nation’s tax revenues. Despite popular belief, it appears that the rich in America do not pay “more than their fair share”, as many argue is the case. Study the graphs carefully, and answer the questions that follow:

Discussion Questions:

  1. Based on the data above, do the rich in America pay an unfair proportion of the total taxes the US government collects? Why or why not?
  2. Why do the richest 5% in America actually pay a lower level of tax on average than the 5% below them?
  3. How much of America’s total income is earned by the richest 1% compared to the poorest 20%? Does America’s progressive tax system destroy the incentive for Americans to work hard and become rich? Why or why not?
  4. Use the data to construct a Lorenz Curve for the United States. Does the gap between the richest and the poorest Americans surprise you? What kinds of changes could be made to the tax system to narrow the gap between the top income earners and the middle and low income earners in America? Should this be done, why or why not?

131 responses so far

Nov 06 2012

A closer look at the crowding-out effect

To spend or not to spend. That is the question. In order to determine whether or not a government should increase its budget deficit in order to stimulate economic activity in its economy, it is important to determine whether said deficit spending will lead to a net increase in the nation’s GDP or a net decrease in GDP. Obviously, if increasing the debt to pay for a government spending package leads to lower aggregate demand in the economy, then it should not be undertaken. However, if a deficit-financed spending package leads to an overall increase in output and national income, it may be justified.

To understand the circumstances under which a government stimulus package will increase or decrease overall output in the economy, we must compare two competing possible impacts of a government stimulus. The multiplier effect of government spending refers to a theory which says that any increase in government spending will lead to further increases in private spending, as households enjoy more income and thus consume more and firms, which earn more revenues due to the government’s increased spending, make new capital investments, contributing to the stimulus provided by government and leading to an overall increase in GDP that exceeds the increase in government spending.
The crowding-out effect, on the other hand, refers to the theory that any increase in government spending, when financed by a larger deficit, will lead to a net decrease in private expenditures, as firms and households face higher interest rates due to the governments’ intervention in private financial markets. Government spending will crowd out private spending, thus any increase in spending will be off-set by a decrease in private spending, possibly even reducing overall income in the nation.
This post will focus on the second of these effects, and attempt to explain the circumstances under which crowding-out is likely to occur, and those under which it is unlikely to occur.
Deficit-financed government spending refers to any policy that increases government expenditures without increasing taxes, or one that reduces taxes without reducing government expenditures. In either case, a government must increase the amount of borrowing it does to pay for the policy, which means governments must borrow from the private sector by issuing new debt in the form of government bonds.
When a government must borrow to spend, it has to attract lenders somehow, which may require the government to offer higher rates of return on its bonds. The impact this has on the supply of private savings, which refers to the funds available in commercial banks for lending and borrowing in the private sector, will be negative. In other words, the supply of loanable funds in the private sector will decrease.
The graph below shows the market for loanable funds in a nation. The supply curve represents all households and other savers who put their money in private banks, in which they earn a certain interest rate on their savings. The demand for loanable funds represents private borrowers in the nation, who demand funds for investments in capital and technology (firms) and durable goods and real estate investments (households). The demand for loanable funds is inversely related to the real interest rate in the economy, since higher borrowing costs mean less demand for funds to pay for investment and consumption.
When a government needs to borrow money to pay for its deficit, private savers (represented by Slf above) will find lending money to the government more attractive than saving in private banks, since the relative interest rate on government bonds is likely to rise. This should reduce the supply of loanable funds in the private sector, making them more scarce and driving up borrowing costs to households and firms. This can be seen below:
In the illustration above, a government’s deficit spending crowds-out private spending, as firms and households find higher interest rates less attractive and thus demand less funds for investment and consumption. Private expenditures fall from Qe to Q1; therefore any increase in economic output resulting from the increase in government spending may be off-set by the fall in private spending. Crowding-out has occurred.
Another way to view the crowding-out effect is to think about the impact of increased government borrowing on the demand for loanable funds. Demand represents all borrowers in an economy: households, firms and the government. An increase in public debt requires the government to borrow funds from the private sector, so as the supply of loanable funds fall, the demand will also increase, although not from the private sector, rather from the government. The effect this has can be seen below:
 –
In the graph above, both the reduced supply of loanable funds resulting from private savers lending more to the government and the increased demand for loanable funds resulting form the government’s borrowing from the private sector combine to drive the equilibrium interest rate up to IR2. The private quantity demanded now falls from Qe to Qp, while the total amount of funds demanded (from the private sector and the government  now is only Qp+g. This illustration thus shows how an increase in government borrowing crowds out private spending but also leads to an overall decrease in the amount of investment in the economy.
Based on the two graphs above, a deficit-financed government spending package will definitely crowd-out private spending to some extent, and in the case of the second graph will even lead to a decrease in overall expenditures in the economy. This analysis could be used to argue against government spending as a way to stimulate economic activity. But this analysis makes some assumptions that may not always be true about a nation’s economy, namely that the equilibrium level of private investment demand and the supply of loanable funds occurs at a positive real interest rate. There are two possibilities that may mean the crowding-out effect does not occur. They are:
  • If the private demand for loanable funds is extraordinarily low, or
  • If the private supply of loanable funds is extraordinarily high.
When might these conditions be met? The answer is, during a deep recession. In a recession, household confidence is low, therefore private consumption is low and savings rates tend to rise, increasing the supply of funds in private banks. Also, firms’ expectations about the future tend to be weak, as low inflation or deflation make it unlikely that investments in new capital will provide high rates of return. Home sales are down and consumption of durable goods (which households often finance with borrowing) is depressed. Essentially, during a recession, private demand from borrowers is low and private supply from households is high. If the economy is weak enough, the loanable funds market may even exhibit an equilibrium interest rate that is negative. This could be shown as follows:
 –
 –
Notice that due to the exceedingly low demand and high supply of loanable funds, 0% acts as a price floor in the market. In other words, since interest rates cannot fall below 0%, there will be an excess supply of funds available to the private sector. Such a scenario is known as a liquidity trap. The level of private investment will be very low at only Qd. Banks cannot loan out all their excess reserves, and even though borrowing money is practically free, borrowers aren’t willing to take the risk to invest in capital or assets that may have negative rates of return, a prospect that is not unlikely during a recession.
So what happens when government deficit spends during a “liquidity trap”, as seen above? First of all, the government need not offer a very high rate to borrow in such an economy. Private interest rates will be close to zero, so even a 0.1% return on government bonds will attract lenders. So the supply of loanable funds may decrease, and demand may increase, but crowding-out will not occur because there is almost no private investment spending to crowd out! Here’s what happens:
 –
Here we see the same shifts in demand and supply for loanable funds as we saw in our first graph, except now there is no increase in the interest rate resulting from the government’s entrance into the market. Since private interest rates stay at 0%, the private quantity of funds demanded for investment remains the same (Qp), while the increased government borrowing leads to an increase in overall spending in the economy from Qp to Qp+g. Rather than crowding-out private spending, the increase in government spending has no impact on households and firms, and leads to a net increase in overall spending in the economy.
If the government spends its borrowed funds wisely, it is possible that private spending could be crowded-in, which means that the boost to total output resulting from the fiscal stimulus may increase firm and household confidence and shift the private demand for loanable funds outwards, increasing the level of private investment and consumption, further stimulating economic activity.
So what have we shown? We have seen that in a healthy economy, in which households and firms are eager to borrow money to finance their spending, and in which savings rates are not exceedingly high, government borrowing may drive up private interest rates and crowd-out private spending. But during a deep recession, in which consumer spending is depressed and firms are not investing due to uncertainty and savings rates are higher than what is historically normal, an increase in government spending financed by a deficit will have little or no impact on the level of private investment and consumption. In such a case, governments can borrow cheaply (at just above 0%), and increase the overall level of demand in the economy without harming the private sector.
Crowding-out is a valid economic theory, but its likelihood of occurring must be evaluated by considering the actual level of output and employment in the economy. In a deflationary setting, in which savings is high and private spending is low, government may have the opportunity to boost demand and stimulate growth without driving up borrowing costs in the private sector and decreasing the level of household and firm expenditures.

14 responses so far

Nov 06 2012

To continue stimulus or to pursue austerity, that is the question

Note: This post was originally published in August of 2010. It is being reposted today to support a lesson on fiscal policy in my year 2 IB Economics class.

In the seemingly endless and currently ongoing debate over the role of the government in the macroeconomy, there are two main camps: Those who think the governments of the developed economies have not done enough to get their economies out of recession, and those who think they have already done too much, and therefore need to start rolling back stimulus and reducing deficits.

At the heart of this debate are the two macroeconomic schools of thought, the  Keynesian demand-side theories and the classical, supply-side theories. Two intellectuals have emerged in the last several years representing the two sides of the macroeconomic debate. On the demand-side, representing the Keynesian school of thought, is 2008 Nobel Prize winning economist Paul Krugman. Representing the classical, supply-side school of thought is Harvard economic historian Niall Ferguson. These two have squared off in many forums over the last three years, Krugman arguing for more and continued fiscal stimulus to prop up and increase demand in the economy, Ferguson arguing for smaller deficits, lower taxes and less government spending to increase private sector confidence and thereby supply in the economy.

During our long summer break the two squared off once again in the aftermath of a G20 meeting in which the governments of several major economies from Europe and North America announced plans to begin rolling back the stimulus spending they embarked on throughout 2008 and 2009. The reason for increased “austerity measures” (policies that reduce the budget deficit and slow the growth of national debt), argue global leaders, is to reduce the chances of more countries experiencing debt crises like that experienced in Greece this spring.

International investors realized earlier this year that Greece’s budget deficits were a much larger percentage of its GDP than previously thought, and very quickly decided that Greek government bonds were an unsafe investment. Almost overnight the cost of borrowing in Greece shot up above 20%, bringing investment in the economy to a halt and forcing the government to cut its budget, leading to higher unemployment and reduced social benefits for the people of Greece.  If investors were to look at the growing budget deficits in other developed countries and  then suddenly lose faith in other government’s ability to pay back their debts, then a similar crisis could occur in much larger economies, including the UK, Germany and the United States. Hence these country’s apparent desire to begin reducing deficits and rolling back stimulus spending; measures that may just plunge these economies into an even deeper recession than that which they have experienced over the last two years.

The videos below show the leading intellectuals on both sides of the stimulus/austerity debate presenting their arguments. Below each video are discussion questions to help guide your understanding of their views. Watch the videos and respond to the discussion questions in the comment section below.

Video 1 – Krugman argues for continued stimulus:

[youtube]http://www.youtube.com/watch?v=7-pndXGafUg&feature=related[/youtube]

Discussion Questions:

  1. What are the two “profoundly different views of economics” that are being tested as governments begin rolling back the fiscal stimulus packages of the last two years?
  2. What are three characteristics of an economy in a “depression” according to Krugman?
  3. What is “budget austerity” and why does Krugman think this should not be the first priority of policymakers in the G20 nations?
  4. Why is deflation dangerous according to Krugman?
  5. What is the additional annual cost to the US government of borrowing and spending an additional trillion dollars now? What is the potential additional benefit of more stimulus?

Video 2 – Ferguson argues for austerity and “fiscal regime change”:

[youtube]http://www.youtube.com/watch?v=03CB8pVJkI8&feature=related[/youtube]

Discussion Questions:

  1. Why might the US have to pass spending cuts and tax increases to maintain its “credibility in international bond markets”?
  2. Why would fiscal tightening “choke off the recovery”?
  3. How is the financial crisis in Europe a warning to the US?
  4. How could the “costs” exceed the “benefits” of deficit financed expansionary fiscal policy.
  5. Ferguson proposes a new type of policy that “boosts confidence”. Why will expansionary fiscal and monetary policies fail if private sector confidence remains depressed?

11 responses so far

Sep 27 2012

Understanding the Consumer Price Index – the Fed’s “Drawing Board”

MV=PQ: A Resource for Economic Educators: Some Classroom Resources

Special thanks to Tim Schilling at MV=PQ blog for pointing out the Cleveland Fed’s interesting video series called the “Drawing Board”.

This video introduces the concept of Consumer Price Index as a measure of inflation in the United States, shows how CPI is calculated, and then goes into a bit more detail than perhaps the AP or IB student needs when it introduces a new method of measuring inflation used by the Fed called “median inflation”.

AP and IB students can benefit most from watching up to 4:12. In this first half of the video the CPI is defined, its measurement demonstrated, short-comings discussed and the “core CPI” explained.

Discussion Questions:

  1. Why does the Bureau of Labor Statistics weight different items included in the measure of the consumer price index? What type of good gets a greater weights than others?
  2. What are some of the purposes the CPI figure serves? Why do we care about changes in the price level in an economy?
  3. What is one short-coming of the traditional method used for measuring the inflation rate using CPI?
  4. Why did the BLS decide exclude oil and food prices from its “core CPI” figure?

114 responses so far

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